Will Political Drama Hurt Europe’s Economy?

The IBEX 35, an index of Spain’s most liquid stocks weighted by market cap, was off as much as 3.1 percent on Monday, pulling its five-day losses to 8.6 percent. The slide brings year-to-date losses to 2.6 percent, an underwhelming start to 2013 after 21.8 percent gains over the previous six-month period.

The story of the IBEX index is one of volatility and decline. The index is off 16.6 percent since its inception in 1992, and has fallen over 47 percent since late 2007, when the financial crisis hit. The index’s six-month rally, a sign of hope for investors and international creditors who are working to pull Spain back from the brink of collapse, is overshadowed by 7.1 percent year-over-year losses.

Like any good market crash, the early-February crash in the IBEX is punctuated by political scandal and tremendous stakes. This week, Spanish Prime Minister Mariano Rajoy, who instituted the harshest austerity measures in the country’s democratic history in order to curb the deficit and ensure international support for its collapsing financial industry, was accused of accepting and distributing illegal payments to party members…

The market response to the allegations was immediate and obvious. The yield on the 10-year Spanish bond shot up 22 basis points to 5.43 percent as uncertainty brewed. European finance ministers have worked for a long time to revitalize investor confidence in the Spanish markets, but political drama always threatens to undermine economic stability.

Rajoy has, of course, denied the claims. German Chancellor Angela Merkel, who has been instrumental in providing support to Spain, stands behind him. Rajoy’s severe austerity measures have been praised by those who are a few steps away from the country’s unemployment rate of 26.6 percent, but criticized by those directly involved. Economists see austerity as a road to recovery, the unemployed see it as an anchor.

Meanwhile, the markets see political unrest as a liability. Heading into the close of regular trading in Europe, London’s FTSE 100 was off 1.6 percent, Germany’s DAX was off 2.5 percent, and the STOXX 50, an index of euro-zone stocks, was off 3.1 percent.

The buck doesn’t stop at Spain, either. February brings with it elections in Italy that threaten to restore former Premier Silvio Berlusconi, who, like Rajoy’s opponents, wants to put a stop to severe austerity measures and unwind tax hikes. A banking scandal in the country has helped give Berlusconi leverage against Prime Minister Mario Monti, who helped steer the country through the crisis and is running for re-election.

The Italian economy shrank 2.4 percent in 2012 and is expected to shrink again in 2013. Italy’s official unemployment rate sits at 11.2 percent, and factory activity, which accounts for as much as 19 percent of economic output, has contracted for 18 consecutive months. As Europe’s third-largest economy, its leadership has tremendous influence over the direction of the region’s economy.